by Vito Tanzi As the global mobility of financial capital and highly skilled individuals increases, the space for governments to protect citizens through taxing and regulating that movement is shrinking. Instruments of social protection Governments have aimed at providing social assistance and protection to their citizens through the use of three major instruments: a) public spending; b) the structure of the tax system; c) the regulatory framework.      Each of these instruments has been used to assist particular groups. To some extent, each instrument has been preferred in particular countries at specific times. However, in most countries these instruments have been jointly used in varying proportions. Thus, some countries have ended up with large public spending, others with high tax rates and much distorted tax systems, while still others have ended up with over-regulated economies. A few have combined all these characteristics.      While public spending has been the preferred, or the most obvious, instrument for providing social protection to the majority of the population – and most economists have associated the welfare state with that spending – the structure of the tax system has also played a significant role. This role is additional to the financing role of taxation. The tax systems have often been used to support certain socially desirable activities through the provision of ‘tax expenditures’, a concept developed in the United States in the 1960s. These tax expenditures became especially significant in Anglo Saxon countries, which showed more resistance to large increases in public spending than European countries.      The tax systems of many countries have been characterised by various tax expenditures provided in support of socially desirable objectives. For example, in some countries, some educational expenditures have been allowed to be deducted from taxable incomes. Some health expenditures have received similar treatment, in addition to the fact that the implicit income value of health benefits has not been taxed. Pensions have received favourable treatment, either because they have not been taxed or because the contributions to pension schemes have been exempt. Individuals with particular disabilities or conditions, such as blindness, or simply old age, have received tax advantages: for example, double personal exemptions in the United States or reductions in the property tax liabilities. Large families with low incomes have received special deductions, such as earned income credits.      Many countries have pursued their social objectives not through public spending or tax expenditures but through regulations. In fact, one could almost identify regulatory welfare states. Through particular regulations, governments have implicitly subsidised some individuals and taxed others, without having actually to collect taxes or spend money. Various forms of social protection have been promoted, for example, through the regulations of labour markets, housing markets, financial markets, access to several public services, and through other channels. The impact of globalisation      If globalisation affected the government’s ability to raise high tax levels, to provide tax expenditures, or to use regulations to achieve particular domestic objectives, it would inevitably have an impact on social protection. If less protection were given through tax expenditures or through regulations, there would be more pressure to compensate with more public spending. However, if the government’s ability to finance this spending were also reduced, some negative impact on traditional social protection would be inevitable.      The impact of globalisation on the welfare state may come from various channels, some more general than others. It may come from the increasing competition that globalisation brings about and thus from the need for more efficiency. It may come from the increasing mobility of factors of production, especially financial capital and individuals with great ability. It may come from international pressures to level the regulatory playing field or to introduce uniform standards or codes of conduct. These channels are likely to become more important with the passing of time. Thus, effects that are barely noticeable now will become more visible later.      With globalisation, financial capital and highly skilled or highly talented individuals become much more mobile because their options expand to other countries. The loss of such individuals and the outflow of financial capital can have a negative effect on the growth rate and on the tax revenue of a country. The point is that, in an open world, where foreign competitors face lower taxes and fewer constraining regulations, it becomes more difficult and more costly for a country to maintain high taxes and more regulations.      Globalisation brings strong pressures on the international community to level the international field in which individuals and enterprises operate. Thus, existing rules about foreign trade, about the environment, about cultural and health-related protection, about the operation of financial sectors, about transparency in fiscal accounts and in accounting standards in general, may need to be changed.      However, the most direct and powerful impact of globalisation will probably come through its effect on tax revenue. There is now a growing literature on globalisation and tax systems, which identifies some of these effects. Some of these are: increased travel by individuals which allows them to shop, especially for expensive items, in places where sales taxes are lower; increased activities on the part of highly skilled individuals outside of their countries, which allows them to under-report (or not to report at all) their foreign earning; growing use of electronic commerce and electronic transactions in general, largely taking place outside of the tax system; growing importance of off-shores and tax havens as conduits for financial investments; the growth of new financial instruments and agents for channelling savings, such as derivatives and hedge funds. (Many hedge funds operate from off-shore centres and are not, or are little, regulated. In many cases, unless or until these incomes are repatriated and declared as incomes, their taxation will remain problematic.); growing importance of trade that takes place within multinationals, among their different parts situated in different countries; growing inability of countries to tax, especially with high rates, financial capital and also incomes derived by individuals with highly tradable skills; the possibility that real money may begin to be substituted by electronic money in the normal transactions of individuals.      These are examples of the brave new world we are entering. It is possible that the world community might be able to develop ways of dealing with some of them or of introducing new taxes. However, it is unlikely that actions will be taken that will deal with the problem. The fall in revenue might come at the same time when governments experience the need for more spending in particular areas, either as a consequence of population ageing or of globalisation itself. Under current policies, the ongoing demographic changes will create strong pressures on governments to spend more on health and pensions. These effects will become particularly pronounced, in many countries, in about a decade from now when the baby boomers will begin to retire. But by that time the effects of globalisation on the tax systems could become particularly strong. Vito Tanzi is Director of the Fiscal Affairs Department at the International Monetary Fund. Tel: + 1 202 623 8723 Fax: + 1 202 623 4259 Email: vtanzi@imf.org